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Submitted to
Prof M.Vedavalli
By
Chintamaneni Rajesh
PGDM-Finance
Roll no 258/2014
Calculating how much life insurance you need is one of the most important financial
decisions an individual will ever make. It should never be an isolated decision depending
only on how much of a premium one can afford.
Having said that, there are many ways in which one can determine how much insurance a
person need.
x6
x8
$60,000
$360,000
$480,000
$80,000
$480,000
$640,000
$100,000
$600,000
$800,000
Expense/Cash Need
Amount
Mortgage
$80,000
Personal Debt
$15,000
$15,000
$50,000
Total
$160,000
Using the expenses assumed above, insurance requirements using this rule at various gross
salary amounts are as shown:
Gross Salary
Gross Salary x 5
Expenses
Insurance Required:
(Gross Salary x 5) + Expenses
$60,000
$300,000
$160,000
$460,000
$80,000
$400,000
$160,000
$560,000
$100,000
$500,000
$160,000
$660,000
Basic Allocation
6% x Salary
Dependent Allocation
(3 Dependents x 1%) x Salary
Premium Allocation
$60,000
$3,600
$1,800
$5,400
$80,000
$4,800
$2,400
$7,200
$100,000
$6,000
$3,000
$9,000
Under this rule of thumb, you determine the percentage of your income to be spent on life
insurance premiums and then buy as much life insurance as you can get for that premium
amount.
When considering term insurance, the percentage of income allocated for premiums is often
calculated at 2% or 3%.
d. Multiples of Salary Method
The multiples of salary method requires the use of a multiples of salary chart and is based on
the assumptions that the family has one income provider and that the average family can live
adequately on 75% of the income provider's salary. Here's how to calculate the estimated life
insurance need:
1. Using the sample chart that follows, find the column showing the age of the
nonworking spouse
2. Find the factor on the chart where the nonworking spouse's age intersects with the
working spouse's income from the column on the left
3. Multiply the income amount by the multiplier factor from the chart
4. Add the result using the multiplier chart to the estimate of final expenses and debt
See the explanation following the chart for ages and incomes that fall between columns.
Multiples of Salary Chart
Current Age of Nonworking Spouse
Income
25
35
45
55
$15,000
4.5
7.0
8.0
7.5
$20,000
5.5
7.5
8.5
7.5
$25,000
6.5
8.0
8.5
7.5
$30,000
7.0
8.0
8.0
7.0
$40,000
7.5
8.5
8.0
7.0
$50,000
7.5
8.0
7.5
6.5
$70,000
8.0
8.0
7.5
6.5
If the age or income is different than those shown on the chart, it is possible to calculate the
amount of insurance needed by using interpolation. For example, if the income is $60,000
and the age of the nonworking spouse is 50, the result can be found using the amounts and
ages immediately before and after the actual figures. In this case, take the multipliers for the
ages 45 and 55 with the incomes of $50,000 and $70,000 and use the average, because the
actual figures lie halfway between the chart figures. The factors are highlighted as shown:
45
55
$50,000
7.5
6.5
$70,000
7.5
6.5
Expense/Cash Need
Amount
Mortgage
$80,000
Personal Debt
$15,000
$15,000
$50,000
Total
$160,000
Multiplier Result
Estimated Need
$420,00
$580,000
Rules of thumb are simple to calculate and easy to understand. The calculations can be done
using a basic calculator. They are useful as a rough starting point and can provide a
framework for you to start with in assessing your insurance need. Keep in mind that they are
very general and fail to consider individual circumstances. While the rules of thumb can be a
helpful starting point, they fail to consider the needs and circumstances of the individual.
There are no considerations of the ages of the insured or the dependents or whether the family
is provided for with one income or two. There are also no adjustments made for special
circumstances, such as the expenses associated with a special needs child or the need for
liquidity for estate planning.
Gender
Occupation
Yearly salary
Employment benefits
Readjustment period income needs - a period of one or two years following the
insured's death in which the family should receive the same income as when the
breadwinner was alive. The readjustment period income provides a cushion period for
the spouse to adapt to their new situation.
Children's income needs during their dependency period - when the insured's children
are under 18 at the time of that person's death, the family should receive income
during the dependency period, i.e. the period between the breadwinner's death until
the children reach age 18. The income needed may vary from family to family
depending on whether the spouse is on the labor force or plans to remain at home to
look after the children.
The surviving spouse's income needs - for a spouse who is under age 60, who has
been unemployed for years and whose youngest child has reached 16, the need for
income in the case of the family head's death is particularly urgent. This is especially
true if the insured dies during the blackout period (the period from the time Social
Security survivor benefits terminate to the time they are resumed).
The spouse's retirement needs - the need for the surviving spouse's adequate
retirement should be considered.
Special needs
Any additional family needs that are not covered by any of the above categories. Different
funds can be established to cater for these needs, including an education fund, an emergency
fund, a mortgage-repayment policy, and other major-debt-repayment policies (for cars or
other non-mortgage long-term debt).
The Method that I would prefer and is mostly followed by reputable financial planners for
decades is the Needs Analysis Method. Once you determine the amount of life insurance
need, just buy the lowest cost insurance plan that's available to you.
You should buy insurance after a thorough calculation of capital (lump sum needs on death
such as paying off a loan, daughter's marriage or education) as well as the income needs of
your family after you are gone.
One should ask itself: If something were to happen to me, what kind of corpus would my
family need to maintain their current lifestyle, to fund my child's education as I had
envisaged, retirement income for my wife etc.
Most middle-class individuals have insurance policies in the range of Rs 1,00,000 to Rs 10
lakhs. Some of the wealthier ones have more than this.
The question one need to answer is: How long would Rs10 lakhs suffice?
Keeping that statement in mind one should estimate his insurance needs , so that his loved
ones are never short of funds.